OSLO, Feb 28 (Reuters) - The Norwegian government should extend most of the restrictions it imposed on mortgage lending early last year, but a special measure for the capital city can be discontinued, the bank regulator (FSA) recommended on Wednesday.

The central bank backed most of the FSA recommendations, although the two differ over how much leeway they think banks should have in offering exemptions to borrowers.

The Finance Ministry tightened its restrictions on banks’ mortgages in January 2017 in a bid to limit household borrowing and prevent a potential house price bubble, with a particular focus on reining in the Oslo market.

Housing prices have since fallen, and in November the ministry asked the FSA to evaluate whether the rules should be adjusted. The ministry will come with its own decision at a later stage after a round of public hearing.

Norway has the third-highest level of debt-to-income among OECD countries behind Denmark and the Netherlands. It was 231 percent according to the latest OECD data, almost double the level in 1995.

The rules that were introduced last year, and which were due to expire in June, force borrowers to put up more equity when buying a home by cutting the maximum loan-to-value ratio of a mortgage to 85 percent from 90 percent.

This measure should now be extended indefinitely, the FSA recommended, adding that it could be altered at a later time if necessary.

For Oslo however, current rules allow only a 60 percent loan-to-value for secondary homes, preventing many investors from buying up property, which economists say has contributed to a fall in the capital’s housing prices.

“In light of the geographical developments in the housing market, the FSA recommends ending the particular Oslo measure,” it wrote in a letter to the Finance Ministry.

Current rules allow banks to make exemptions for up to 10 percent of borrowers, while the FSA sought to cut this to just 8 percent. The central bank disagreed, arguing that this so-called speed limit seems well-adapted to the current situation.

“We still expect housing prices to continue to fall this year, as we had based our forecasts on continuation of the regulation in line with today’s proposal,” she said, while adding that a turnaround may begin towards the end of 2018. (Reporting by Camilla Knudsen and Ole Petter Skonnord, writing by Terje Solsvik, editing by Gwladys Fouche and Hugh Lawson)